Moving Money - Messaging and Settlement

In part 2 of this short series we will look at how commercial banks and the Central Bank adjust their ledgers to make money 'move' between institutions. We also summarise how card payments are settled within a single jurisdiction/currency.

Picking up where we left off we have Bob, a customer of Bank A, who has just made a payment of £25 to Charlie, who banks with Bank B. How did this happen?

On receipt of Bob's payment instruction Bank A reduced the balance on his account and then sent a message to Bank B to increase Charlie's balance. Now before Bank B will action this request they want to know that their balance with the Central Bank has been correspondingly adjusted in their favour. They can then go ahead and pay Charlie.

Gross Settlement

To secure this confirmation the payment instruction message ① from Bank A to Bank B is held en-route whilst a corresponding settlement request ② is sought from the Central Bank. The Central Bank then adjusts the reserve balances of Banks A and B accordingly and confirms with a settlement response message ③. The settled payment instruction message is then released ④ to Bank B who can action it. Finally a notification ⑤ is sent to Bank A to confirm the transaction is complete.

In the UK this service is called CHAPS (Clearing House Automated Payment System) with the messages routed over the SWIFT (Society for Worldwide Interbank Financial Telecommunication) network.

It is worth noting that whilst SWIFT carries the necessary messages the actual balance adjustments are made by the Banks themselves. This process, called Gross Settlement, takes place in real-time, i.e. almost instantaneously, and is ideal for large value payments. However, if every payment where settled in this way it would require all banks to maintain large precautionary balances with the Central Bank to cover the worst case scenario that they were asked to make a sequence of large value payments in succession.

Net Settlement

An alternative approach is to take advantage of the fact that whilst Bank A will issue payment instructions to Bank B, Bank B will also issue similar instructions to Bank A. If we bundle these transactions together over a period of time we can calculate the net position between the banks and then ask the Central Bank to make the aggregate adjustments instead. This is called Net Settlement and requires less funds to be tied up in Central Bank accounts.

The Faster Payments system in the UK works this way, settling with the Bank of England three times a day. In this case both the messaging and the balancing calculations are carried out by another partner, Vocalink.

The payment instruction is sent from Bank A ① to Bank B ② via the Vocalink network. Bank B confirms ③ via Vocalink to Bank A ④ usually in near real-time. Periodically the outstanding net balances are adjusted via the bank's reserve accounts with the Central Bank ⑤,⑥. Transfer notifications are then set from the central Bank to Bank A and Bank B ⑦.

As a consequence of delaying the settlement process there is a trade off. Either Bank B delays paying the recipient until the net settlement process has completed or alternatively it accepts some risk that between actioning the payment instruction and the settlement transaction completing, the originating bank goes bust and is unable to reimburse them. For this reason Bank B may place a limit on the value of net-settled transactions it will accept.

Single Jurisdiction Card Payments

Card payments are another example of a net settlement scheme, albeit with a few variations. Credit and Debit cards are offered by issuing banks and can work across a number of different networks (VISA, Mastercard, Maestro, Interlink etc). Debit transactions are paid for by reducing the balance the bank owes the card holder and Credit transactions are paid for as a debt the card holder owes the bank.

Credit payments typically have a two step process: an authorization flow that takes place immediately at the point of sale, followed typically by an end-of-day settlement process. The authorization process checks the card holder has sufficient credit available at the moment of purchase, returning a confirmation message that gives the merchant confidence they will be paid so they can proceed with the transaction and hand over the goods. At this point the transaction may be shown on the card holder's account as pending.

At close of business the merchant uploads their transactions for the day from their POS (Point of Sale) terminal to their payment processor ①. This processor (also known as a merchant acquirer) aggregates these transactions and routes them through to the relevant card network ②. The card network further aggregates the transactions from all the acquirers in their network and then sends each issuing bank a list of the transactions made on the cards they have issued, along with the net position that the bank owes the network ③.

The issuing bank may then make a payment to top-up its settlement account held at the card network's settlement bank ④. The card network then makes payments to each acquiring bank for their portion of the transactions ⑤ and then finally the acquiring bank will pay each merchant's account at their bank for their transactions ⑥.

ATM and Debit transactions typically have a simpler one-step process where the authorization message carries all the information for the issuing bank to settle the transaction in the same way as above.

This completes part 2 of the series. In the next section we will consider how cross-border payments are made via correspondent banking and how the CLS (Continuous Linked Settlement) system works.